Robo-Advisor Tax-Loss Harvesting: What It Means and How It Works

Robo-advisor tax-loss harvesting is the automated selling of securities in a portfolio to deliberately incur losses to offset any capital gains or taxable income within many robo-advisor platforms.

A robo-advisor is an automated investment platform that features very low costs and low minimums due to the use of algorithms so that there is minimal human involvement. Tax-loss harvesting is a program that seeks to help investors pay the lowest taxes possible in non-tax-sheltered accounts following Internal Revenue Service (IRS) guidelines.

Understanding Robo-Advisor Tax-Loss Harvesting

Emergent technology in the financial industry, popularly called fintech, has made it possible for financial services and products to be easily assessed at low costs through investment platforms using smart technology. These platforms, known as robo-advisors, build customized portfolios for users and then monitor and rebalance the portfolios periodically for low and affordable management fees.

One of the numerous services that some robo-advisors offer through their systems is tax-loss harvesting. Tax-loss harvesting is a deliberate strategy whereby any loss from the sale of a security in a taxable account is used to offset a capital gain or taxable income, thereby reducing the tax paid.

For example, an investor who has a capital gain of $15,000 and falls in the highest tax bracket will have to pay 20%, or $3,000, to the government. But if they sell XYZ security for a loss of $7,000, their net capital gain for tax purposes will be $15,000 - $7,000 = $8,000, which means that they will have to pay only $1,600 in capital gains tax.

There is a catch, though. The IRS wash-sale rule prevents the investor from repurchasing XYZ or a security that is substantially identical to XYZ within 30 days from its sell date, though the definition of “substantially identical” seems to be vague. An investor who wants to maintain exposure to XYZ may be better off purchasing a mutual fund or exchange-traded fund (ETF) that tracks the sector in which XYZ operates.

Performing a tax-loss harvest can be tedious, complicated, and expensive for the average investor, which is why a couple of robo-advisors have included this value-added strategy as part of their services. Robo-advisors typically create and manage personalized asset portfolios using ETFs. Robo-investment platforms have an algorithm in place that incorporates computational rules like the 30-day IRS wash-sale rule. When a realized gain is made, the system will sell a losing investment to counteract the gain but will not be able to repurchase the same security due to the algorithm.

Rebalancing Example

Robo-investment platforms have automated metrics in place to ensure that an investor’s portfolio always remains balanced. After a sale is made, in order to keep the portfolio balanced or maintain exposure to the same industry, the system will purchase another ETF to replace the sold one.

For example, Wealthfront, a robo-advisor that offers tax-loss harvesting services, could sell the Vanguard Total Stock Market ETF to harvest a loss and then purchase the Dow Jones Broad U.S. Market ETF. Since both are positively correlated and provide the same exposure, Wealthfront can maintain the optimal risk-return allocation of the portfolio without violating the IRS rules on substantially similar investments. After the 30-day wash sale period, the original ETF may be repurchased.

Using our XYZ security example from above, let’s consider a scenario where the gains and loss values are switched. If the investor has a capital gain of $7,000 and a capital loss of $15,000, $7,000 from the capital loss can be used to completely offset the capital gain to $0. The remaining $8,000 of the capital loss value can be used to reduce the investor’s ordinary income for tax purposes.

The IRS stipulates that only a maximum capital loss of $3,000 can be claimed against ordinary income in any given year. The remaining $5,000 can be rolled forward and applied against an individual’s ordinary income in subsequent years.

Advantages of Robo-Advisor Tax-Loss Harvesting

Robo-advisors have made tax-loss harvesting more accessible. These automated systems basically keep a watch 24/7 for ways for you to minimize your taxes. If it all goes to plan, you could end up saving thousands without impacting the strength or balance of your portfolio. And if that money is reinvested, you have the chance of making even higher returns.

Being savvy with taxes is a key part of smart investing. Do it right and you can save on your tax bill and boost returns.

Disadvantages of Tax-Loss Harvesting

Having a computer automatically modify your investments isn’t necessarily a good thing. Most investors buy stocks with plans to hold them over the long term and therefore, they shouldn’t be selling them when the price is low and they have made a loss. Selling a stock you’re convinced about during a rough patch is counterproductive. As the old mantra says, you should be buying low and selling high, not the opposite.

The wash-sale rule can lead investors to trip up as well. Some people may think they can just buy the security back or immediately purchase something identical. The IRS won’t accept that. If you do not pay attention to the 30-day rule, you will no longer be able to claim the capital loss.

It’s also worth bearing in mind that extra activity comes at a cost, in terms of transaction fees, and that you’ll need records of every purchase to give the IRS the correct cost basis. Moreover, tax-loss harvesting might work against you if your tax rate ends up being higher in the future.

Robo-Advisor Tax-Loss Harvesting vs. Financial Advisor Tax-Loss Harvesting

While many traditional financial advisors only run a tax-loss harvest once a year due to it being a time-consuming and labor-intensive process, the best robo-advisors can run these processes daily without human intervention.

A financial advisor cannot identify the numerous tax-loss harvesting opportunities that are available in multiple portfolios. A robo-advisor, on the other hand, is usually on the alert during a market downturn to capitalize and execute on tax-loss harvesting opportunities that come up. Wealthfront has stated that their automated robo platforms can create an additional annual return of 1.11% to 1.98%, depending on the tax burden of the investor. Betterment has stated that 0.77% is what a typical investor can expect for an additional annual return.

The Bottom Line

For many years, tax-loss harvesting, which is selling securities at a loss to offset a capital gains tax liability, was such a complex and time-consuming process that many investors didn’t bother with it. Robo-advisors have helped to change that. Automated tax-loss harvesting has suddenly made it easier and cheaper to save on taxes without impacting the strength or balance of your portfolio.

Most robo-advisors offer this service and take care of everything for you. In many cases, signing up for this service seems to be a no-brainer. However, there can also be some drawbacks. Tax-loss harvesting isn’t for everyone and doesn’t always necessarily make sense.